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Game theories

The half a trillion dollar question: is Tencent on the way to match Apple’s valuation?

The cast of characters from nearly a decade of Week in China reporting has changed as time has progressed. Early headlines tended to feature companies in steel, coal and iron ore, buoyed by the massive stimulus campaign that followed the global financial crisis in 2008. Later they were as likely to come from the telecom sector, including equipment maker Huawei and national carrier China Mobile, or the state-owned train-makers.

Tencent got its first mention in 2009, a few months after its archrival Alibaba. But it wasn’t until the social media boom a few years later that it started to feature on a weekly basis. Since then it has been an ever-present force, not only in reshaping China’s internet but also in reaching deeply and disruptively into other sectors. It has transformed itself in the process into one of the world’s most influential companies and raced past $500 billion in market value last year, much to the delight of its investors.

Those long years of growth and success meant that last week’s headlines were rather unusual for longstanding Tencent watchers: its first fall in quarterly profit for thirteen years. What went wrong and does it portend problems for Tencent in future?

Why was it seen as surprising?

Tencent reported profits of Rmb41.1 billion ($5.98 billion) in the fiscal first-half ended June, an increase of 26% from the same period last year. This looks like a pretty solid performance for such a large company, but investors were spooked by the quarterly results, as its profit in the March-to-June period fell 2% year-on-year to $3.3 billion, marking the first decline of its type since 2005. Quarter-on-quarter, its net profit even dropped 23%, while revenue growth was flat.

The mood was a stark contrast to last year when the company had a stellar run, more than doubling its market capitalisation. The media response was relentlessly positive as well, including a feature from us in which we asked whether Tencent was now China’s most admired company (see WiC367).

Last week’s results were worse than expected but the change in narrative started to take shape as early as March when Tencent’s shares showed the first signs of weakening. Long-accustomed to the company’s outperformance, the analyst community seemed slow to adjust, with only one out of 52 respondents polled by Bloomberg two months ago venturing a negative outlook for the stock. Maybe that meant the results last week came as more of a jolt, with the company’s shares in Hong Kong shuddering downwards by another 10%, taking their decline to more than a third below the peak set in January. Almost $180 billion of market value had gone up in smoke in the calendar year, or the equivalent of just over two Goldman Sachs.

Blame it on gaming licences?

Coverage of Tencent’s troubles was tempered by the acknowledgement that last year’s rise in the share price was so dramatic. On top of that there is the anxiety about Beijing’s trade and technology row with Donald Trump, which has put a dampener on market sentiment in general. Tencent isn’t at the risk of having its operations disrupted in the same way that Washington kneecapped ZTE because it makes most of its money in China and doesn’t have the same dependencies on the global supply chain. But in becoming a key holding of many global investment funds, it has become a victim of its own success. Talk of the worsening confrontation over trade has been turning investors skittish and they have retreated from emerging markets, pulling out capital.

Most of the media reports have focused on problems closer to home for Tencent, however, especially in its gaming division, which delivers about a third of its revenues. As we discussed three years ago in a Focus Issue on the struggle for mastery of the Chinese internet, the impetus for much of Tencent’s early success came from the expansion of its customer base through video games and connected web services. It is now the largest video game publisher and investor in the world, and owns or has major stakes in most of the world’s top selling titles. But sales growth in gaming has stalled this year and revenue from games played on smartphones, a key area, fell a catastrophic 19% on the previous quarter.

One reason is consumer behaviour: more and more Chinese are watching more short-videos from streaming sites like Douyin, and playing games less.

Tencent has shrugged off the concerns, pointing to difficulties with government approvals. In the case of two of the most popular titles, the authorities have been unexpectedly slow in giving the green light for Tencent to charge fees for the games, so it hasn’t been able to earn any income. Another of the blockbusters was pulled from sale after regulators said they weren’t happy with the content. Tencent works with game developers to make the Chinese versions of their titles less gory (substituting green splodges for blood in one case – to make it more like a confrontation between monsters rather than people killing each other). But the revamps haven’t always been enough to satisfy Chinese censors and the blockages in the sales pipeline have penalised Tencent in the pocket.

The company counters that the slowdown in licencing is the result of a reorganisation at the nation’s regulatory body and that the disruption is temporary. “From a revenue growth perspective, gaming is a key area of weakness and our biggest game is not monetisable,” Martin Lau, the company’s president, admitted on the earnings call with investors. “The administration is also aware of the fact that because of the restructuring it’s now affecting the industry as a whole.”

In the past Tencent’s promotion of gaming has worried the government, which is concerned about its addictive influence on the younger generation (see WiC374 and WiC390). The authorities have adopted a less tolerant approach since Xi Jinping came to power, pulling the plug on content said to be violent or compromising to socialist values. Perhaps there is more focus on consumer protection at the moment as well, following high-profile scandals in the vaccine industry (see WiC419) and the implosion of peer-to-peer lending.

More than just a gamer

More than 3,000 games are held up in the approval process (not just Tencent’s) and it is too early to think that Tencent is being targeted by the authorities, although a couple more quarters in which new games are delayed or denied might change the picture.

There’s even a counterargument that more onerous regulations could help Tencent by putting pressure on smaller gaming firms without the resources to last out the delays. International game developers may gravitate more towards Tencent too, reasoning that it is most likely to have the nous to navigate China’s regulatory risks.

Certainly, in the internet world Beijing has so far looked favourably on Tencent as a homegrown champion with the requisite scale to take on America’s tech giants. But Tencent will need to tread carefully as it encroaches into new areas like financial services, healthcare and transportation, where it is stepping onto the turf of longer-established operators, many of them under state ownership.

A few weeks ago Beijing announced changes in the rules for customer cash held by Tencent’s payment app, which must be deposited with custodian banks by January. Because these deposits won’t earn interest income, Tencent will forego billions of yuan in lost revenue (see WiC418). Situations like these make it essential that it plays its political hand deftly (something that its boss and founder Pony Ma is said to devote more time to now, according to a recent Fortune magazine profile). Official support can be withheld, after all, as witnessed by the downfall of the over-ambitious insurer Anbang.

Back at its earnings announcement, Tencent made the point of showing progress in areas other than games, talking up customer engagement across its social media platforms and noting more monthly average users and more fee-based subscriptions, especially for online video.

Its video service has already surpassed 63 million paying users and it seems set to be spun-off, while its music streaming unit may also go public later this year after being valued at more than $12 billion based on a share swap with Swedish streaming giant Spotify.

Besides, Tencent has reported stronger sales from online advertising than usual, where income rose 39% year-on-year in the second quarter, and it has started the process of monetising more of its social media audience by doubling daily ads to two per WeChat feed, although its bosses will be cautious about flooding the platform with advertisements.

What about WeChat? Is it still China’s killer app?

There are two main business models for social media platforms: one relying on advertising and the other more concentrated around value-added services for customers. Tencent adopts the latter, and unlike Facebook it isn’t reliant on advertising for its survival. Indeed, its diversity in income streams counts as one of its key strengths.

The foundation for Tencent’s success is WeChat, its free-to-use social media and messaging app, which funnels more than a billion people towards Tencent’s revenue-generating attractions like music, video and gaming.

Some of the recent press coverage of WeChat has suggested that its reputation as a category killer is under review, however. In part that’s down to the view that user numbers can’t keep growing at the same pace (perhaps that’s true, although the latest findings from the China Internet Information Center are that a stunning 42% of the population still didn’t have internet access as of June this year).

Another factor is the challenge from newcomers, especially Toutiao in news and Douyin in short video. Both are owned by Bytedance, a six year-old start-up that is turning into an aggressive Tencent rival.

The rise of Toutiao and Douyin puts them into direct competition with WeChat as a destination for internet users to consume news and video. As we highlighted in WiC416, Douyin has enjoyed a spectacular growth spurt, scoring more downloads on Apple smartphones than WeChat, YouTube and Facebook between February and June. Toutiao has grabbed the crown in news aggregation, with industry-leading artificial intelligence that recommends articles and videos based on its readers’ interests.

Tencent is trying to hit back with news aggregators of its own and one of them, Qutoutiao, has just announced that it is planning an IPO in the United States. Toutiao’s fans argue that the Tencent platform is a pale imitation of its rival, however, forcing it to concentrate on less affluent customers in lower-tier cities, and the competition with Bytedance has been combustible and even led to legal action (see WiC411 and WiC416).

“Bytedance has built an alternative ecosystem of news and entertainment apps which, while smaller, now rivals Tencent’s ecosystem for where Chinese users will go to kill time on their phones, where advertisers look to spend advertising yuan online and where media or influencers look to distribute content. They’ve done the hard work and built up a lot more than just a foothold,” warns Matthew Brennan, a specialist on Tencent and the author of an upcoming book on WeChat. “Tencent has a nimble and dangerous independent competitor of scale in the local market eating up time from their pan-entertainment empire. That’s what investors should be concerned about”.

Tencent isn’t just a social media and gaming brand anymore?

One of Tencent’s key strategies in response to rivals like Douyin and Toutiao is the promotion of Mini Programs, smaller applications that run instantly on the WeChat interface without needing to be downloaded from app stores.

The idea is to capture more of the daily activities of WeChat’s customers and Tencent highlighted some of the new services at last week’s earnings call, including features that make it easier for transport operators to charge for journeys, retailers to make home deliveries, and restaurants to reduce queuing times

Outside of WeChat, Tencent has broadened that approach by investing in hundreds of tech startups from food delivery to bike-sharing.

The list is a lengthy one, including stakes in unicorns such as ride-hailing app Didi Chuxing, online healthcare firm WeDoctor, internet-based educator VIPKid and the autonomous driving electric vehicle car brand Nio (also planning a US listing). In addition there are shareholdings in companies that have already made their market debuts, such as e-book marketplace China Literature, and e-commerce firms such as JD.com and Pinduoduo (see page 9).

Backers of the strategy say that Tencent is spreading its bets by aligning with a deeper range of products and services that should reinforce its position at the forefront of social media. Meituan Dianping – another of its major investments – uses Tencent’s messaging apps to bring in business for its food delivery services, for instance, while Sogou’s search engine is embedded as the default WeChat search engine.

Tencent also benefits because most of these investments hold value in their own right and it has monetised more of these stakes in the past year and a half than any of the traditional private equity or venture capital investors (see page 13 for more on this topic), booking heady profits as many of the unicorns come to market.

One of the criticisms is that the gains from Tencent’s portfolio are being reported as operating income, distracting attention from the performance of its core business. Tim Culpan at Bloomberg has been complaining for a while that the company’s quarterly numbers have been boosted by gains in the companies in which it has invested, obscuring less convincing gross margins, which have been dropping. “By stripping out the entire ‘other gains’ category – which I think should be reported under non-operating items anyway – I found that rather than climbing, operating margin slid from 29.4% a year ago to 26.8% in the most recent period. When revenue jumps 51% but operating margin slides, you start to realise that economies of scale aren’t quite what you imagined,” he warned back in March.

In the most recent quarter Tencent’s investment portfolio actually worked against it, with decreases in disposals and increases in provisions pulling down operating income by 51% year-on-year. Shares in companies like China Literature, which had doubled in value from its Hong Kong debut last November, have fallen below their IPO price, and the situation is similar for search engine Sogou, which debuted in New York at a similar time.

The other concern about the frenzied focus on dealmaking (it has invested in around 600 portfolio companies in the past six years) is that Tencent is spreading itself across too many sectors and that the company is losing sight of the kind of organic experimentation that fostered the creation of WeChat.

This rebuke first made headlines in May when Pan Luan, a former editor at tech portal Huxiu, attacked the company for channelling too many of its resources into investment opportunities rather than innovating in its core business (see WiC409).

The warning was similar from Liu Suhong on Sina, another news site, in a follow-up critique on Tencent’s unfocused approach last week. “Tencent’s investments aren’t launched deliberately around its main business, which is evident from the listed companies in which it has invested, plus the companies that will submit for IPOs,” he said. “The investment income that these investments have won for Tencent is successful from a short-term, financial view, but it will be inferior from a strategic perspective over the longer term.”

Liu says too that the philosophy that helped Tencent triumph in the worlds of social media and gameplay won’t prove as successful elsewhere, including its ‘horse racing’ approach to product development that sees it try out lots of new ideas before a small group comes through as winners. “Now they are using the same idea for investment and it may not work,” he predicts.

Yet this pick-and-mix approach in venture capital can have merits, it seems, especially in generating new revenues across Tencent’s commercial empire.

As Louise Lucas noted in the Financial Times on Wednesday, Tencent wants more than shareholder payouts from its investees. Meituan is expected to cough up as much as Rmb3.6 billion in fees for marketing and promotional support by 2020, for example, as well as for the additional cloud, technical and payment services that Tencent provides.

Pinduoduo is a similarly committed customer, Lucas added, paying $33 million in service fees in the first three months of this year.

New income like that will bolster Tencent’s bottom line and its shares have shown signs of life since the sell-down last week, rebounding by about a tenth as of Wednesday. Its longer term prospects will pivot on how well it deals with the challenges to its supremacy, however. In the short term it needs to fix its problems with game licences and ward off some of the more immediate threats to WeChat traffic flows from Bytedance by winning new customers and keeping them on the platform for longer periods. And in the longer view, it will need to keep its partner-picking strategy coherent, looking for outsized returns from the unicorns in which it chooses to invest, but always with an eye on how best to integrate them into its billion-plus customer ecosystem.

And of course while it skirmishes with Bytedance it faces a bigger, broader war both at home and abroad with Alibaba – the only Chinese internet rival with the resources and financial firepower on a scale to match Tencent’s own.

Much cash will be burned in that fight (exhibit one: Meituan’s plunging pre-IPO valuation; see WiC420). After nearly a decade of covering both companies, it remains difficult to predict which will be the first to join Apple in the trillion dollar club. Tencent’s Ma will hope his big bets in e-sports (see WiC410) may prove the next avenue of spectacular growth.

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